Crossing systems designed to enable the execution of large block orders encounter the difficulty of focusing liquidity at the same point in price and time. Various solutions to this problem have been deployed. Various electronic markets offer scheduled crosses at specific points in the day. For example, Pipeline and LiquidNet attempt to attract crossing blocks at any time of the day by delivering invitations to trade to potential counter-parties and offering mechanisms to facilitate convergence in price. These methods succeed only to the extent that large buyers and sellers have latent liquidity ready to be routed to the market and not previously committed to another strategy. As a result, fill rates on orders committed to crossing systems are low, typically 1-5% depending on the stock's liquidity.
To bridge the gap in time and strategies, liquidity providers willing to commit capital can take on a position on the crossing system and wind it down at a different time or using a different strategy. However, the price of the block trade on the crossing system then becomes a principal driver of profitability for the liquidity provider, creating a direct conflict of interest with the institution that had committed its block order to the crossing system. The liquidity provider has an incentive to game the execution price on the crossing system by buying the block lower and retaining the difference as part of its trading profit.
Crossing systems have devised various mechanisms to prevent potential damage to their customers' interests. LiquidNet simply precludes the participation of liquidity providers. Pipeline protects the institutional order's interests via a large minimum quantity, hiding the side, using orange and yellow indicators to give an informational edge to resident aggressive orders, fuzzying the time when these indicators are turned on or off, and enabling an order's limit price and time in force to remain unknown. POSIT randomizes the execution time.
Of these systems, only POSIT enables liquidity providers to participate profitably, but it falls short in protecting the institutional order, as liquidity providers can probe the crossing system with small quantities to discover an imbalance in large buy/sell interest and later trade accordingly on the continuous market. Pipeline's rules, in contrast, have proven themselves to be effective at protecting the resident order, with the result that liquidity providers acting on a regular commission-based pricing model have not found it profitable to trade on the system, even when their commissions are reduced all the way to zero.
Standard rebate models such as those used by ECNs provide a negative commission, typically limited to $0.002 per share. These payments are too small to cover adverse information costs associated with large block orders. To the extent that they could be raised to a level sufficient to attract liquidity providers to larger blocks, one would still be faced with a strong incentive to find ways to game the crossing system's pricing mechanism. The solutions described above would be only an imperfect remedy, likely to diminish but not eliminate the damage caused by predators looking to game the execution price.
What is needed is a mechanism for providing rebate payments that enables liquidity providers to participate and raise crossing rates dramatically, while neutralizing the incentive to game the execution price on the block crossing system.
Embodiments of the subject invention relate to software-based systems and methods for encouraging capital providers to facilitate trades with good execution quality on a block trading system.
Embodiments of the system subject of the present invention overcome the limitations of known liquidity rebate payment systems by calculating rebate payments in a manner that neutralizes (preferably, exactly neutralizes) the incentive to game the execution price on a block crossing system.
The combination of higher crossing rates and execution quality provides a strong value proposition to the user, thereby enabling the crossing system that uses this rebate mechanism to strengthen customer loyalty and sustain a premium price that can be used to offset the cost of the rebate mechanism.
In one aspect, the invention comprises a system for enabling a crossing system operator to calculate a rebate payment to a second participant for executing the block order of a first participant based on at least one of: (a) a difference between a benchmark price and an execution price of the block order; (b) total volume of block execution; and (c) an amount that decays exponentially with the time between the first participant's order and the order's execution by a liquidity provider.
In another aspect, the invention comprises a system for enabling a crossing system operator to calculate a rebate payment to a first participant upon execution by a second participant of an order placed by the first participant, based on at least one of: (a) a difference between a benchmark price and an execution price of the block order; (b) total volume of the block execution; and (c) an amount that decays exponentially with a time between the first participant's order and the order's execution by a liquidity provider.